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Although analysts have detected “Green Shoots” in the economy signaling the possibility that there may be a recovery occurring sometime soon, it is my belief that we will need to see some signs of life in the banking system before we can get too excited about any sustainable upswing. Right now, I don’t see any “Green Shoots” in the area of commercial banking.

The only indication that something might be starting to happen in the banking sector is the apparent “credit thaw” in the money markets. An article in the Wall Street Journal touts the “voracious demand for short-term debt issued by U. S. and European banks.” We are told by one New York trader that “bank commercial paper ‘flies off the screen.” (See Credit Thaw Is Spurring Appetite for Bank IOUs) The London interbank offer rate has dropped and relative interest rate spreads have fallen, indicating that confidence is returning to this sector of the money market.

Yet commercial banks are not lending. They are not lending to each other and they are not lending to businesses. Commercial banks are still reducing their own debt or just holding onto the cash! The only lending that seems to be happening is on pre-approved home equity loans and on pre-approved credit card balances and other revolving consumer credit. Year-over-year, the change in total commercial bank lending and leases is roughly zero.

In terms of banks lending to other banks, from June last year to June this year, the decline in Fed Funds lending and reverse repurchase agreements with other banks has dropped 15%. These loans have dropped another $60 billion in the four week period ending July 15 from a total of $319 billion!

Credit risk is not the reason that the commercial banks are not lending to each other. In normal times, commercial banks lend to each other through the Federal Funds market or through using repurchase agreements in order to manage their reserve positions at the Federal Reserve. However, these are not normal times.

Commercial banks really don’t need to lend to each other in order to manage their reserve positions at the Federal Reserve because they are over-whelming liquid!

Note that in the two weeks ending July 15, the Federal Reserve reported that excess reserves in the banking system totaled $743.9 billion dollars! This is up from $1.9 billion in July 2008. Commercial banks have no concerns with meeting their reserve requirements because they are holding reserves at Federal Reserve banks that are far in excess of what is required. And, why should there be any trading of Federal Funds when there are such excesses within the system.

The commercial banking system is recording cash assets, as of July 15, 2009, of $958.7 billion which is up from $320.0 billion in the month of June 2008.

Right now, the lending market seems to be compressed on both sides of the market, supply as well as demand. Not only do banks seem to be reluctant to make loans, there seem to be a dearth of borrowers at this time.

The argument on the supply side is that commercial banks still have two major concerns on their minds. The first is the value of assets on their balance sheets. In terms of asset values, there still is the problem of mortgage foreclosures. We are starting a period of re-pricing of Alt-A and Option mortgages at a time when unemployment impacts are growing. Next year there is apparently another round of re-pricings of subprime mortgages. Credit card losses continue to rise. And, there are still big problems expected in commercial real estate loans. This says nothing about the securitized loans that are still on the books of the banks. The second concern of the banks is who to lend to if they were to make loans. Given the uncertainties with respect to the strength of the recovery and the state of the labor market commercial bank lending practice has reverted to the principles of the “good old days” which begin with “don’t lend to anybody that needs to borrow.”

The demand for loans is tepid at best. De-leveraging and saving are the primary focus of a large portion of the business and family population. Small businesses and individuals are scared enough that they are shrinking their needs for outside funding and are looking more and more to greater self-reliance. Experts in the field don’t see this new behavior pattern changing soon. More larger firms that possess some degree of financial strength seem to be moving to take advantage of the economic distress of others and so they are borrowing more, but not from the commercial banks.

The consequence of this? Commercial and industrial loans at commercial banks have declined by more than $120 billion this year. Consumer loans have declined by $30 billion since February 2009. Real estate loans have remained roughly constant this year.

There is still one more factor that is weighing on the minds of commercial bankers. The Federal Reserve has created a situation in which commercial banks have ended up with well over $700 billion in excess reserves. The question on the minds of commercial bankers is when and how will the Federal Reserve remove these excess funds?

It is obvious from his testimony in front of Congress last week that Chairman Bernanke does not have an “exit strategy” for the Federal Reserve to remove these reserves from the banking system.

My question to you is, “Would you lend out these reserves if you had no idea when the central bank was going to take them away from you?” I certainly would not! I think any banker that wanted to put these excess reserves to work under the current leadership of the Federal Reserve would be foolish!

There may be indications that money markets are warming to the commercial banking sector and this is good. However, this is not putting money out into the economy. We need to keep looking at the commercial banking sector to see when lending starts to pick up. Until it does, consumers and businesses will just have to rely on their own resources to finance a recovery. This does not bode well for a rapid turnaround.

Source: In the Commercial Banking Sector, No Green Shoots Yet